What is Bond Duration?

Bond duration is a measure of the volatility of a bond's return over time. It measures the price reduction of a bond, over the change in interest rate of the bond. It is slightly correlated to how long it takes for the bond to mature, but it is not an exact relationship. To better understand the way a bond's duration affects its value, consider the factors that make a bond risky.

Bond Default

The most basic risk in purchasing a bond is the chance the bond issuer will default. If the issuer goes bankrupt, the investor will not get her money back. The investor will additionally lose any expected annual return due to interest rate. This is less likely to happen with a government bond. Bonds for large corporations are not considered as risky as bonds for small corporations. However, all investment involves risk, and default is the most basic risk with a bond.

Price Reduction of a Bond

Any public body, including the US Government, can issue a bond. A bond is a debt note. The purchaser buys the bond at a given price, receives a small interest payment each year, and is then paid back when the bond matures. One risk for a purchaser is a drop in the price of a bond. For example, if a purchaser buys a $50 bond one month, the body selling the bond could potentially lower the price for the same bond next month to $40. Now, if the original purchaser wants to sell the bond on the secondary market, that purchaser will not make back the full amount. The purchaser will have to hold the bond until its price increases again, which is not guaranteed.

Interest Increase of a Bond

There is a possibility a bond issuer could actually raise the promised interest rate on a bond in the future. If a purchaser buys a bond at 5% interest, for example, the issuer could raise the interest to 6% next month. This typically occurs if inflation has increased or if the Federal Reserve has issued a rate increase. This means the borrower would have made more money on the purchase if he had waited just a few more months. Again, this means the borrower will also have a harder time selling the bond on the secondary market and may need to reduce the bond price.

Tracking Duration of a Bond

The duration of a bond tracks these two possible problems. The duration, simply put, is the reduction in a bond's price divided by the increase in its interest. There are online calculators that can help investors calculate bond duration. Before investing in a bond, a purchaser can track a bond's duration to learn exactly how risky the purchase is. Longer duration bonds have more risk. They will take longer to repay their true value, and they will have more exposure to risk during that period of time. A longer maturity period will reduce a bond's duration. A smaller coupon payment will reduce a bond's duration. These two elements are often opposing, meaning two very different bonds can have the same duration.

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